Sean Egan, one half of the dynamic duo who (alongwith Bruce Jones) foundedEgan-Jones Ratings Co. back in the early 1990s and has been a thorn in the side of the ratings industry’s grand dames ever since, gave me a call the other day to bring me up to speedon the pair’s latest venture. As it turns out, Egan-JonesPerformance Servicesis as radical, and as obviously a good idea, today, in equities research as their indepen- dent, investor-funded credit rating business was back when they were just getting it started. What’s so radi- cal? Start with independence, an Egan-Jones trademark. They avoid conflicts-of-interestlike the plague, with a simple business model: Selling timely, accurate, strate- gic long and short calls, to investors who are willing to pay their freight. It works because Egan-Jones’approach to credit research encompasses not just traditionalratio analysis, but a systematicand continuing assessment of a company’s business and competi- tive position and any other factors that could influence valuation. Which has proven, time andagain, to provide advance warning or disasters-in-the- making as well as profit oppor- tunities. A number of which Sean shares in this interview. Enjoy. KMWI have to tell you, I’ve been a fan of the way you’ve shaken up the credit ratings business for some time, Sean. Well, we are an irritant to S&P and Moody’s and to alesser extent, Fitch— Irritants are good. I based my early career on being an irritant. Still, Moody’s and S&P would prefer that we go away. In fact, there’s a story onBloombergthis morningsaying that they have upped their lobbying budgetfrom $1.5 million per year to $1.9 million per year. I guess that means it’s getting more expensive to buy votes— Let’s say that I guess they believe in putting their money where their hopes and paychecks are—because they’re trying to block the opening up of the credit rating industry. No surprise there. But they’ve lost some ground in that battle, haven’t they, lately? It’s not entirely clear. The House Committee on Financial Services has approved a bill that they sayis intended to increase "competi- tion, transparency, and account- ability in the credit rating indus- try," the so-called Credit RatingAgency Duopoly Relief Act of2006. It was introduced last year by Pennsylvania Republican Michael Fitzpatrick and now has been sent on to the full House. ButI wouldn’t begin to predict what will happen there. In the Senate, [Richard] Shelby has held several hear- ings before his BankingCommittee—some of which I’ve participat- ed in—and he is supposed to introduce a bill within the next 60 days. So perhaps, maybe, finally the SEC will do its job [and approve more NRSROs —or have that responsibilitytaken away from it. You dreamer, you. We have no problems with Reprinted with permission of welling@weeden JUNE 30, 2006 PAGE 1 RESEARCH DISCLOSURES PAGE 8 VOLUME 8 ISSUE 12 JUNE 30, 2006 INSIDE Listening In Sean Egan Talks About Longs And Shorts His FiercelyIndependent Firm Has Found AmongEquities ByStudying Credit; Why DetroitIs A ShortPAGE 1 Street Beat Calling CEO’s Bluff: Is Smulyan PuttingEmmis In Play & Sen at or’ s Wife On Hot Seat? Guest Perspective CharlesGave: Could New F orm Of Portfolio Insurance Be Driving V olatility? Talk Back Acute Observations Comic Skews ALL ON WEBSITE Egad! Egan-Jones Independent, Investor-Centric Credit Analysts Take Aim At Equities listening in http://welling.weedenco.com In Memoriam Douglas R. Gillespie, Sr. (1945 - 2006) Reprinted from
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the current rules, as stated. The issue is that the SEChasn’t been following those rules. They say that youhave to be a nationally recognized statisticalresearch organization and a few other things, that’sthe main requirement. But you know, we have muchmore national recognition in the U.S. . And by the
way, we have much more national recognition, in theUnited States, than DBRS [Dominion Bond Rating
Service Ltd.]—yet when we point that out, they’recompletely silent. Anyway, we continue the fight.People in Washington are interested now because of all the Enrons and WorldComs, etc. Standard & Poors
and Moody’s Investor Services stood up and tried tosay there was no way they could have caught thoseproblems—that the reason that they got Enron and
WorldCom wrong was because there was fraud. But we stood up and said that there is always fraud when
we have these debacles.The job of the credit ana-lyst is to cut through that
to see what is really going on. So we’ve become a poster boy for people whoare trying to reform thisindustry.
Isn’t the essentialproblem with the creditrating industry relatedto its disregard of avery simple principlewe all learned—orshould have—at our
parents’ knees: “Whosebread I eat, his song I sing.”
Yes, exactly. You’re right. As we all know, the SEChas forced a $1.4 billion settlement on the equity research analyst side of Wall Street for conflicts of interest during the internet bubble. Why in the
world would the regulators not see that there issomething similar on the fixed-income side? I can’t imagine, but they don’t see the connection there. Sothey’re continuing to do what they’ve alwaysdone—at least, until they’re forced to change. But weare hopeful that change will happen fairly soon.
You’ve been fighting that battle for a long timenow, haven’t you?
We’ve been at this, issuing credit ratings, sinceDecember of 1995 and it’s worked out very well forus.
Didn’t you actually start your company a cou-ple of years before that?
Yes. We formed the f irm in 1992. We started out doing consulting work for institutional money man-agers.We didn’t start issuing credit ratings untilDecember of ’95. That was long ago enough, at thispoint, that there have actually been some studies
done about the accuracy of our reports—one from theFederal Reserve Board of Kansas City—and even a
skeptic like you has to know that we couldn’t manip-ulate the Federal Reserve Board—
Heaven forbid! Yes. We’re lucky if we can even get the attention of our local congressman. We have no influence at theFed! And there are other studies of our ratings, onefrom Stanford Journalism, one from Michigan, that
have been done now—and have been helpful. Onething we’ve always done differently is look at the
whole company, not just a specific bond issue, when we do our analysis. So as a result of our credit work we have been able to look at companies and evenequities a little bit differently than other people do.
We try to cut through the PR and find out what’sreally driving a company.
For instance? We have been bearish onGeneral Motors (GM) andFord (F)for quite some
time—and we continue to be so. Even though a lot of people are celebrating
because it looks likeDelphi might not go onstrike now and a lot of autoworkers are accepting
buyouts, but we still seetoo many fundamentalproblems remaining at GM and Ford to celebrate.people are accepting the
buyouts, but we see some
fundamental problems remaining with GM and Ford.
I want to pursue those with you. But before wego too far down that road, let’s be clear. Isn’t theessential difference in the way Egan-Jonesapproaches credit ratings that you aren’t paid bythe companies whose securities you analyze?
Well, if we an speak informally, it’s that—and that wesimply don’t believe a lot of garbage.
You mean you approach your work with a mod-icum of skepticism?I think it’s well placed. A perfect example was the
WorldCom case where S&P and Moody’s used toclaim that they were so close to the company, that they knew exactly what was going on. The problem isthat being close to a company often times doesn’t help them. They’re blinded by the public relationsgarbage that companies are feeding to the invest-ment community.
You’re saying they were spellbound by BernieEbbers’ line of bull, and got fooled?
Yes, exactly. In fact, Moody’s now-retired chairman,Clifford Alexander, sat on the board of WorldComfor ten and a half years. He resigned, I think, about
eight months before they filed before bankruptcy. SoMoody’s was right there, had a seat in WorldCom’s
Reprinted with permission ofwelling@weeden JUNE 30, 2006 PAGE 2
boardroom, and yet they couldn’t act. Either they didn’t see the informa-tion or didn’t want to seethe information. But they failed to warn investors.
Your WorldCom
reports, by contrast,did not make for pleas-ant reading in theEbbers household?No, they hate us, andrightly so. A lot of compa-ny managements hate us
because we don’t neces-sarily believe what a lot of those managers are say-ing. I have yet to meet a CFO or a Treasurer whodoesn’t believe that his
company’s shares areundervalued or that hisdebt is underrated. They all think that.
How right you are. Andthe bigger the bullmarket, the more they’re convinced.Exactly. But that’s not to say that we’re always bearish. Take Nextel
as an example. We have been bullish on that company for a long time—were bullish. Obviously, they’ve been taken out now, withtheir merger with Sprint, creating Sprint Nextel (S). But our rating on Nextel at one point was six notches above S&P and Moody’s.
Wow, six notches? Yes, that’s huge. And it’s interesting: How, in the same basic indus-try, did we have one rating, on WorldCom, that was way below S&Pand Moody’s, and another rating, on Nextel, that was much, muchhigher than S&P and Moody’s?
I assume you’re going to tell me–I think the explanation is that there is a bias on the part of S&P andMoody’s in favor of the large important issuers. WorldCom, obvi-ously, was a huge investment banking client. So we were cutting across the grain by saying that the company had significant prob-lems. It was the same kind of thing with Enron, by the way.
Whereas Nextel was big—there was no doubt about it—but it just didn’t have the voice or presence in the investment community that
WorldCom had.
Sure, one necessary step in creating a really big investmentfraud is hitching your company’s wagon to Wall Street’sperpetual financing machine.
Yes. Fannie Mae (FNM) and Freddie Mac (FRE) are beautiful at that, by the way.
Aren’t they?Oh, they’re the best at that. We don’t rate them anywhere nearAAA.
I have the sense that with Fannie and Freddie we’re experi-
encing the investment equivalent of the Night of the Living
Dead .I like that analogy.
They’re “living” proof that financial institutions can be toobig to fail.
It’s funny; we rate them at about A or A minus.
That highly? Well, what we’d really like to rate them is probably about a singleB+ or so. The reason why we don’t is because—our credibility—ourrating is low enough so that we wave a red flag. I mean, it’s proba-
bly four or five notches away from S&P and Moody’s AAA. Thentoo, you have to give some credence to the idea that theGovernment will probably step in. But on a stand-alone basis, or if
you assume that it’s only the $2.2 billion credit line that would beavailable from the Treasury, then they should be rated way down inthe single-B or BB category.
Ah, the bond world is still so much more of a polite and gen-teel place than the equity markets.I agree. Just think about it—Fannie and Freddie don’t have to put upany margin with the brokers dealers, because they’re rated AAA by S&P and Moody’s. It’s all so incestuous.
That alone must must be worth zillions–Imagine what would happen if they didn’t have even a portion of their supposed portfolio profits to report. We doubt that they actu-ally have those profits; we doubt that real capital is there. And it seems like every couple of months another accounting fiasco sur-faces either at Fannie or Freddie.
They’re still finding the corpses.Our other major issue with them is that we question whether any-
Reprinted with permission ofwelling@weeden JUNE 30, 2006 PAGE 3
one really can effectively hedge a trillion-dollar-plus portfolio.
’m sure they have hired somebody from MIT who thinkshey’ve got it done.
Right, except when it comes down to it, there is no one on theother side of all those trades.
Either that, or everyone is on the other side of those
rades, which is the same thing.That’s a good way of putting it. You and I and every other taxpayer
re actually on the other side.
Let’s turn to a less dismal topic. You and your partnershave just started offering equities research, as an offshootof your credit work, under the Egan-Jones PerformanceServices banner. Was that to assist analysts and PMs whoorgot how to read balance sheets during the bull market?’m not touching that! It was more of a natural progression, since
we were looking at the whole companies, anyway, for our credit atings service. Because we were getting the credit calls right, we
knew we had the data, the methodology and an ability to identify
ikely changes in equity prices—long term, not short term—becausehanges in credit pricing generally precede changes in equity pric-ng. Still, until recently the demands of building the Ratings
Company, kept us so busy that we just never got around to actually producing an equity performance product. We always had theechnology, but for all those years, we just never did it.
Undoubtedly we had (and still have) a tiger by the tail, and weprobably left some money on the table. But now we’re focused.
How did that happen?t was when I gave a presentation at my friend Jim Grant's spring onference. I went into the equity implications of our credit rat-ngs product—talked about being able to anticipate strategic
hanges in equity pricing. Then, at the end of the presentation, Iwas overwhelmed with guys wanting to talk about our equity per-ormance “product.” Well, it didn't really exist—at least not in a aleable, presentable, public format. So it was then, at the Grant’sonference, that I turned to Pete Arnold, who does marketing for
us, and we both laughed and said, “Gee, I think we better do this.”That was March 29th. It then took about a month to get the not-so-new product into presentable form. But, of course, we are stillmproving it. We already have a number of very happy hedge guys,he sort who take a strategic view, as launch clients for our “Long Short Performance Product” and it seems to be very well-receivedy both equity and fixed-income guys. We’re promising clients 40trategic long/short calls a year.
s it too soon to say what sort of investors find it mosthelpful?Well, this may sound very odd. And it is definitely a simplification.But even some of the people who identify themselves as valuenvestors these days see a decline in the price of a stock andssume, just because it previously traded at a higher price, that here’s some value there.
Then they’re not very good value investors.Exactly. They should at least be checking the soundness of its bal-
nce sheet and making adjustments to the financials to get somekind of normalized operating income and get a sense of where the
ompany is going. And that’s what we have always tried to do withvery company that we look at. Then too, as we observe many
growth investors, we often see them acting more like momentuminvestors than anything else. That it’s, they’re not sitting back andassessing whether or not this company is able to sustain its growthand whether there’s going to be new competition that comes intoits market, what might happen to the margins going forward, theinvestment rates. But we’re trying to assess those questions withevery company that we look at.
You’re making a big assumption these days—that someonewants to hold a stock for more than a nanosecond or two.And isn’t just buying or selling it as part of some packagetrade.Exactly. That’s a bad assumption in many cases, we recognize that.
And you’re doing it in a pretty tough market for indepen-dent research—It is very tough, but we have been able to identify opportunitiesthat other people haven’t been able to see. Perhaps it’s because of the way we look at companies differently than the typical analyst,
because of our background on the credit side, but we’ve been for-tunate in our calls. They’ve panned out pretty well, on both the
long and short sides of the market. What we’re doing for the equi-ties service is culling out those cases where it appears that thereare aberrations in the market—where the valuation assigned by equities investors appears to be off. The cases where we especially shine are those where we see some difficulties with the company sustaining itself.
When the stock market sees only wine and roses?Exactly. As in Enron and WorldCom, which were early examples.More recently, I’m sure you saw the articles and reports asserting there was no way Delphi was going to file for bankruptcy protec-tion, because GM would always support them. But not from us. Wequestioned whether that was possible because GM was—and
is—having enough difficulty of their own. We made other timely calls on Northwest Airlines (NWACQ) and RiteAid (RAD). Now, air-lines in general are looking a little bit better, just because thedemand for travel has been fairly strong. That’s what has kept a number of them out of bankruptcy over the past 12 months,despite fuel prices that have obviously increased.
That and the fact that they’ve generally been too strappedto leverage up and go out and blow a bunch of capital onnew planes. But you did recently express doubts aboutJetBlue. (JBLU)Exactly. The story on JetBlue has changed. It used to be the low-cost, low-leveraged airline that was flying in major metropolitan
airports and was really the new darling in the discount airline sec-tor. The problem is that Southwest Air (LUV), which is the Wal-Mart of this industry, is now entering those major markets. They did not do that before. They felt they could not compete head-to-head against the legacy carriers. But now Southwest has crossedthe Rubicon. They’re in Philadelphia and they’re entering othermajor markets too. So JetBlue is hemmed in in that way. Not tomention that JetBlue is not that low-leverage airline that it used to
be. It has taken on a lot of debt to grow. It has sold off some air-craft, I think, within the past month, but that still doesn’t signifi-cantly alter their high leverage. Now, JetBlue’s stock has donedecently over the past month or so because of the rise in the wholeairline industry. But it remains a highly leveraged company whose
base market is under attack from Southwest Air.
Reprinted with permission ofwelling@weeden JUNE 30, 2006 PAGE 4
evel for Ford. But the point, in terms of our industry matrix, is that here’s a huge spread in funding costs between a AAA credit like
Toyota and a Ford or GM that’s now carrying a speculative rating.
What else counts on that matrix of yours?mage is another big factor, and the way we capture that is by look-ng at that the quality surveys and perhaps also at the luxury sedan
market, which often drives an automaker’s whole brand image. In
he latest J.D.Powers survey, again, Toyota and Lexus were way upon top, and GM and Ford were closer to the bottom.
And they can only sell so many monstrous Escalades .Yes. Among luxury sedans, GM used to be in good shape with itsCadillacs, but it’s rare to see a Cadillac anymore, at least in thisarea in the country. You see gobs of Lexus vehicles and, of course,Mercedes and BMWs and Acuras, but you see relatively few tradi-ional Cadillac sedans. And when it comes to Ford, you don’t see
anything, really.
Around Manhattan, you do see lots of Cadillacs being drivenby the various black car services—
But outside Manhattan, those disappear. And that’s significant because luxury sedans really set an auto brand’s image. That’s alsowhere the carmakers probably make the most money, in sedans.But Ford and GM have been all-but locked out of that market. Andhey probably stay locked out for the foreseeable future. Then, theast factor in our matrix is recent earnings.
sn’t that an oxymoron for Ford and GM?t’s terrible and we don’t think it’s going to get better anytimeoon. GM, on a pre-tax basis, had $15 billion of losses last year. Andf the accounting board has its way, they’re going to have to recog-
nize $60 billion in unfunded healthcare liabilities—that you really can’t shrug off as just a “one-time” event. Because if you take that
$60 billion and spread it out over the last 10 years, it means that GM was, has been and continues to be —
Overstating whatever slim profits it managed to report?Yes, exactly. They are a walking zombie. They’re dead and they don’t know it.
Did you see the recent Wall Street Journal piece that neat-y dissected how much of the pension costs it is alwaysmoaning about aren’t obligations to the rank and file likeeverybody assumes, but are actually the result of super-charged executive pensions?No, I did not.
’d recommend it. [As Workers' Pensions Wither, Those for
Executives Flourish , by Ellen E. SCHULTZ and Theo Francis,June 23] GM wasn’t the biggest offender cited. But it wasup there.’m sure that’s going to make it easier when GM negotiates with the
unions.
Anyway, what you’re saying with your matrix is that Fordand GM really aren’t competitive on any meaningful levelwith Toyota?When we line all these things up on our matrix, even though weknow some people believe that Ford and GM could be shrunk back
o profitability, we have a real problem with that notion. For theimple reason that there really isn’t any place to hide. You know,
both companies might be able to—if their senior managements would really focus on it—maybe shrink down to, let’s say, sell someprofitable SUVs and trucks. Maybe they could just go after that seg-ment of the market, like Harley Davidson goes after the motorcyclemarket, and sell just to people who want an American truck and are
willing to pay a 10% or 15% or 20% premium for that. But there’sno way that the current management is going to do that. They’renot even going to entertain a strategy like that until they’ve been
forced to file for bankruptcy. It’s easier for Mr. Wagoner to just make people feel better about things with these buyouts and hopeto stay in the saddle for another year or two, than to take drasticaction like that. And he wouldn’t get support from the UAW, any-
way, so they really couldn’t do it. The UAW basically owns the com-pany. They can’t do anything without the UAW’s approval.
Weren’t you encouraged that they at least sold GMAC, evenif they didn’t get as much as some hoped for it?Not really. It went for below book value. When was the last time a financial services company was sold for below book value?
It’s been quite a while.
It certainly has been. I can’t remember one. The last couple big sales have been of retailer credit card operations and those have all
been for premiums. So the price they accepted for GMAC is an indi-cation of how difficult things are. If you’re putting zero interest rates, six-year loans into that operation, you have to know that thecompany is pushing the envelope as much as possible. In fact thezero interest and other incentive programs both companies areputting into motion assure us that Ford and GM will report operat-ing losses. What’s going on here, quite simply, is mutually assureddestruction [See report summary, opposite.]. So that’s why we’renot bullish on GM and Ford. We may be missing something, but wehaven’t found it yet.
Until just this week, it sounded like you were slightly lessbearish on Ford.Only because it hasn’t sold off its crown jewel yet. They still haveFord Credit. That’s a positive. The negative is that Ford probably has a weaker product line-up than GM. Alternatively, GM has high-er relative pension and healthcare costs than Ford. So, they’re neck in neck, roughly, in a race no one wants to be in. I think the only real difference lately has been that GM has had a better PR effort than Ford recently. Bill Ford is exercising with the Detroit Lions
while Rick Wagoner is flying around the country.
If GM’s and Ford’s boards believed you were right, theyshould have filed yesterday.
There’s no question. But it all depends on your perspective. If youare Wagoner and you know you’re going to be tossed on your earupon the filing or shortly thereafter, you’re better off holding on.He has every incentive to hold on, as does Bill Ford and the Fordfamily, while a more rational professional manager who came in
with a clean slate would probably throw in the towel.
In that case, why would any presumably rational profession-al investor be trifling with either equity?I think a lot are for the simple reason that they believe Uncle Sam
will come to the rescue the way we did with Chrysler.
Chrysler was a long, long time ago, in a very different world.
It certainly was. There are also some who believe that GM has beena part of the foundation of the country and always will be, so
Reprinted with permission ofwelling@weeden JUNE 30, 2006 PAGE 6
they’re holding on. But the competition is not letting up. Toyota has a new truck factory that’s coming on later this year. They already have plans to expand it. And they’re looking for anotherfactory. So any oasis that Ford and GM might have is going to van-ish shortly.
What sort of competitors would the Japanese be if theydidn’t try to take advantage of Detroit’s woes?
Similar to the ratings industry, actually. As you know, S&P andMoody’s had terrible (positive) ratings on WorldCom, Enron,Global Crossing, Genuity, Delphi. Sent completely the wrong mes-sages to investors. The SEC says they have been looking at it, but have done nothing. Meanwhile, S&P’s and Moody’s revenues con-tinue to grow. Essentially, the rating agencies are providing all theservice that you could expect from a partner monopoly.
Don’t you mean “duopoly?”No, in our opinion duopoly isthe wrong word because a duop-oly is two firms competing
against each other. But sinceevery issue needs two ratings,okay, S&P and Moody’s don’t compete against each other.They’re partners in every senseof the word. When an offering comes down, S&P gets their feeand Moody’s gets their fee.They’re not negotiating against each other in any way.
And Fitch has traditionallybeen in there as a fig leaf?
Exactly. If Fitch grows toomuch, S&P and Moody’s usetheir monopoly power to leanon the investment banks not togive too much business to them.
No surprise, but having a lotof independent creditresearch out there mightnot always be seen as in theinterest of the investmentbanks—There’s no question. What they
want are lap dog ratings agen-cies. Ones that say something isinvestment grade when it’s fourdays from bankruptcy. And by the way, ones that will giveadvance information to theinvestment banks before they cut a rating.
It’s clear you think highly ofyour own rivals. What aboutGM’s and Ford’s? Have youissued positive reports on
Toyota, for instance?No, because they’re not very
interesting. They are just the Wal-Mart of the auto industry.
Yet that is the way, if I’m not mistaken, that you’ve foundsome of the companies you’ve written up from the longside—Absolutely. But our view is that Toyota and Honda are just going tocontinue to make life very difficult for Ford and GM —and unlessthere’s a dramatic change in the political environment, it’s going to be extremely difficult to fight that.
Still, you haven’t washed your hands of everything con-nected to Detroit. I saw Goodyear (GT) on your positiveslist—
Yes. Goodyear is interesting because even though it’s in the gener-al automotive business, it getsover 60% of its revenues from theaftermarket. That’s point No. 1.Point No. 2 is that it is not solely dependent on the U.S. for manu-facturing. Goodyear can sourceproducts from outside the United
States and so it has some leverageover its domestic operations. Orlet me say that another way: If theUAW shuts down their opera-tions, it will be very difficult— but the company could deal with it.That’s a completely different casethan with GM and Ford, whichdesperately need the approval of the UAW and their other unionsto operate.
Goodyear also has a CEO in who
has been swinging an ax—Absolutely, and that’s what they need. They’re making the right cuts so that they can improveoperations.
What about Goodyear’s bal-ance sheet?It’s been improving. One of thefirst things that we look at,though it’s not directly a balancesheet item, as a measure of finan-cial health, is pre-tax interest
coverage. And that’s been at 2.4-to-1. It’s not terrific, but at least it’s not negative, or below 1-to-1,
which is the case for a lot of othercompanies in the general auto-motive industry sector. AndGoodyear is focusing on reducing debt.
That helps, particularly in arising rate environment.Exactly, and Goodyear hasreduced its debt by $400 million
over the past year. Which is, Imean the net debt is still at $3.7
Reprinted with permission ofwelling@weeden JUNE 30, 2006 PAGE 7
Egan-Jones’ Latest On Detroit: EJR AFFIRMS FORD MOTOR CO AT CCC (NEG.) (S&P: B+)
FORD MOTOR CO EJR Sen Rating(Curr/Prj) CCC/ CCRating Analysis - 6/29/06 Debt: $151.1B, Cash: $39.1BF_060629.htm Buyout Prob.: Low; Value/Price: $1.47/$6.19
FORD Motor Co's (the Company or F) revenues were $41.1 billion for the quarter endingMarch 2006 compared to $45.1 billion for the prior year. The Net Loss realized for theMarch '06 quarter was $1.2 billion, a decline over the prior year's $1.2 billion income.
Mutually Assured Destruction - the zero interest and other offers assure that F andGM will report operating losses. F's share price drop also reduces financial flexibilityand credit quality. F recorded $2.5B in special items for the March quarter and willrecord $3B additional charges in 2006 for healthcare costs. F faces pressure from:supplier support costs, plant closings costs, increased labor costs, increased fundingcosts, declining market share, unfunded pension and healthcare liabilities, increasedproduction costs, and tired product lines. Like GM, F might sell a majority interest inFord Credit to reduce funding costs, but without Credit earnings, F's losses will accel-erate. We rate Ford Credit at BB-/B+.
*Annual Ratios Ratios for 4 Rolling QuartersCREDIT POSITION 12/05 P12/07* 3/05 6/05 9/05 12/05 3/06
PEER RATIOS Sen. Cov(x) Debt(%) Cov(x) ROE(%) Cap(%) Rating*
Toyota Motor Corp. AAA 104.5 212.9 132.0 11.5 7.0 AAA
DaimlerChrysler
AG-REG BBB 4.5 18.4 14.8 7.7 68.2 BB+
Ford Motor Co. B+ 2.4 10.5 13.9 14.5 91.1 B
General Motors Corp.B -4.7 1.9 0.8 -67.6 94.5 CCC
* Using only last reported annual data and not smoothed.Rating Chg Antic. (1 is best, 100 worst): 78.0 Old EJR Sen.: CCC S&P Sen.: B+Copyright Egan-Jones Group, Ltd. No secondary distribution.
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Reprinted with permission ofwelling@weeden JUNE 30 2006 PAGE 8
million, but that’s down from $4.1 million a year ago.So they’re going in the right direction. The majornegative for Goodyear is that their raw material costshave been rising. That reduced March quarter oper-ating income before interest to $238 million from$262 million a year earlier. The company is focusing on reducing costs, but more needs to be done. Still,his is a company with $1.6 billion in cash and, we’d
ay, a decent chance of being bought out. The valueange we put on it is somewhere between $15 and
$35, roughly.
What else has caught your eye, long or short?On the short side, there’s a Canadian company,called Nova Chemicals (NCX). The basic problem withhe company is that its operating income has been
deteriorating just terribly. Just for the Decemberquarter, it’s fell from $59 million in 2004 to a $4 mil-ion loss for December ‘05.
s that because its feedstock is petroleum
based?Yes. They used to have access to cheap Alberta natur-al gas and petroleum. But what used to be cheap is noonger cheap. Its March operating numbers were
more or less as dismal as December’s. They had oper-ating income last March of $170 million—which fello $49 million this March. Their interest expense, inhe meantime, has gone the exact opposite way—
from $26 million up to $42 million, so they don’t have much cushion in their operations.
How did you come across this idea?By virtue of our work on the credit side, where wesaw that unless there’s some dramatic change in thepricing structure, which is tough because the market in chemicals is worldwide, this company was going to
continue to have some severe difficulties. Their rela-tively small size means they can’t become dramatical-ly more efficient than the next firm. Meanwhile,there’s a wholesale shift going on in the chemicalsindustry, with production moving from the U.S. andCanada to the Middle East, where more productioncapacity is being created every year. So its ever moredifficult for Nova to realize the earnings it once did,
but to sustain its structure requires the sorts of mar-gins that it doesn’t have anymore. Barring a buyout,
which seems unlikely with Nova reporting losses, weexpect its shares to remain under pressure.
Okay, let’s end on an up note. Tell me about onemore thing you like here.Veritas (VTS). It is a drilling services company—pro-
vides survey and seismic information and analysis.
The name would be better for a winery. But it’sin a good business to be in these days.No question. I think we first recommended the stock around 45.75; now it’s up to 49. But t he demand fortheir services will continue. It appears to be cheap ona relative value basis. If you look at it on a multiple of EBITDA or EBIT basis, its multiple is much lowerthan the multiples on some similar companies. Plus,there’s a good chance that this one will be bought out
by one of its major competitors.
Relative value can be a slippery slope. Well, the median multiple of EBITDA on comparablecompanies is at 17. We back that down to a 12 multi-ple in our valuation, and we still get an enterprise
value of $140 a share on fiscal ‘07 numbers. And when we do the same thing with EBIT, backing Veritas’ multiple down to 12 from a peer average of 22, it still looks fairly attractively priced. Besides,this company is the right size for somebody who
wants to bulk up to come in and buy. It’s market capis only around $1.5 billion, it has annualized EBIT-DA of $265 million and interest expenses of only $4
million. And it has more cash than debt. Then too, it seems to have developed some proprietary technolo-gy, which they’re using to build up their mapping service. It would be an attractive bolt-on acquisitionfor a number of firms. After all, the demand for andprice of energy is likely to remain robust for the next several years—which will stoke demand and marginsin the energy field. So about the only negative we see
with Veritas is the possibility that it pays up to do toomany share buybacks or gets taken out too soon.Thanks, Sean.
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